Chapter 3 - Audit Planning and Analytical Procedures

Audit Planning and
Analytical Procedures
©2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasley 8-1

Learning Objective 1
Discuss why adequate audit
planning is essential.

Three Main Reasons for
Planning
1. To obtain sufficient appropriate evidence
for the circumstances
2. To help keep audit costs reasonable
3. To avoid misunderstanding with the client

Risk Terms
Acceptable
Acceptableaudit
auditrisk
risk
Inherent
Inherentrisk
risk

Planning an Audit and
Designing an Audit Approach
Accept client and perform initial audit planning.
Understand the client’s business and industry.
Assess client business risk.
Perform preliminary analytical procedures.

Planning an Audit and
Designing an Audit Approach
Set materiality and assess acceptable audit risk
and inherent risk.
Understand internal control and assess control risk.
Gather information to assess fraud risks.
Develop overall audit plan and audit program.

Make client acceptance decisions
and perform initial audit planning.

Initial Audit Planning
1. Client acceptance and continuance
2. Identify client’s reasons for audit
3. Obtain an understanding with the client
4. Develop overall audit strategy

Gain an understanding of the
client’s business and industry.

Understanding of the Client’s
Business and Industry
Factors that have increased the
importance of understanding the
client’s business and industry:
 Information technology
 Global operations
 Human capital
©2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasley 8 - 10

Understanding of the Client’s
Business and Industry
Understand
Understandclient’s
client’sbusiness
businessand
andindustry
industry
Industry
Industryand
andexternal
externalenvironment
environment
Business
Businessoperations
operationsand
andprocesses
processes
Management
Managementand
andgovernance
governance
Objectives
Objectivesand
andstrategies
strategies
Measurement
Measurementand
andperformance
performance
Industry and External
Environment
Reasons for obtaining an understanding of the
client’s industry and external environment:
1. Risks associated with specific industries

2. Inherent risks common to all clients in
certain industries
3. Unique accounting requirements

Business Operations
and Processes
Factors the auditor should understand:
 Major sources of revenue

 Key customers and suppliers
 Sources of financing
 Information about related parties

Tour the Plant and Offices
By viewing the physical facilities,
the auditor can asses physical
safeguards over assets and interpret
accounting data related to assets.

Identify Related Parties
A related party is defined as an affiliated
company, a principal owner of the client
company, or any other party with which
the client deals, where one of the parties
can influence the management or
policies of the other.

Management and Governance
Management establishes the strategies and
processes followed by the client’s business.
Governance includes the client’s organizational

structure, as well as the activities of the board
of directors and the audit committee.
 Corporate charter and bylaws

 Code of ethics
 Meeting minutes
Code of Ethics
In response to the Sarbanes-Oxley Act, the SEC

now requires each public company to disclose
whether is has adopted a code of ethics that
applies to senior management.
The SEC also requires companies to disclose

amendments and waivers to the code of ethics.

Client Objectives and Strategies
Strategies are approaches followed by the

entity to achieve organizational objectives.
Auditors should understand client objectives.
 Financial reporting reliability

 Effectiveness and efficiency of operations
 Compliance with laws and regulations

Measurement and Performance
The client’s performance measurement system

includes key performance indicators. Examples:
 market share  Web site visitors

 sales per employee  same-store sales
 unit sales growth  sales/square foot
Performance measurement includes ratio analysis

and benchmarking against key competitors.

Assess client business risk.

Assess Client Business Risk
Client business risk is the risk that the

client will fail to achieve its objectives.
 What is the auditor’s primary concern?

 Material misstatements in the financial
statements due to client business risk

Client’s Business, Risk, and
Risk of Material Misstatement
Industry and external environment
Understand client’s
business and industry
Business operations and processes
Management and governance

Assess client business
risk
Objectives and strategies
Assess risk of material Measurement and performance

misstatements

Sarbanes-Oxley Act
The Sarbanes-Oxley Act requires that
management certify it has designed
disclosure controls and procedures to
ensure that material information about
business risks is made known to them.
It also requires that management certify

it has informed the auditor and audit
committee of any significant deficiencies
in internal control.
Perform preliminary analytical
procedures.

Preliminary Analytical
Procedures
Comparison of client ratios to industry
or competitor benchmarks provides an
indication of the company’s performance.
Preliminary tests can reveal unusual

changes in ratios.

Examples of Planning Analytical
Procedures
Selected Ratios Client Industry
Short-term debt-paying ability:
Current ratio 3.86 5.20
Liquidity activity ratio:
Inventory turnover 3.36 5.20
Ability to meet long-term obligations:
Debt to equity 1.73 2.51
Profitability ratio:
Profit margin 0.05 0.07
Summary of the Parts
of Auditing Planning
A major purpose is to gain an understanding
of the client’s business and industry.

Key Parts of Planning
Accept client and perform initial planning
 New client acceptance and continuance
 Identify client’s reasons for audit
 Obtain an understanding with client
 Staff the engagement

Understand the client’s business and industry
 Understand client’s industry and external

environment
 Understand client’s operations, strategies,

and performance system

 Assess client business risk
 Evaluate management controls

affecting business risk
 Assess risk of material misstatements

Perform preliminary analytical procedures

State the purposes of analytical
procedures and the timing
of each purpose.

AU 329 emphasizes the expectations

developed by the auditor.
1. Required in the planning phase

2. Often done during the testing phase
3. Required during the completion phase

Timing and Purposes of
(Required) (Required)
Planning Testing Completion
Purpose Phase Phase Phase
Understand client’s Primary
industry and business purpose
Assess going concern Secondary Secondary
purpose purpose
Indicate possible Primary Secondary Primary
misstatements
(attention directing) purpose purpose purpose
Reduce detailed tests Secondary Primary
purpose purpose

Select the most appropriate
analytical procedure from
among the five major types.

Five Types of Analytical
Procedures
Compare client data with:
1. Industry data
2. Similar prior-period data
3. Client-determined expected results
4. Auditor-determined expected results
5. Expected results using nonfinancial data.

Compare Client and Industry
Data
Client Industry
2009 2008 2009 2008
Inventory turnover 3.4 3.5 3.9 3.4
Gross margin 26.3% 26.4% 27.3% 26.2%

Compare Client Data with
Similar Prior Period Data
2009 2008
(000) % of (000) % of
Prelim. Net sales Prelim. Net sales
Net sales $143,086 100.0 $131,226 100.0

Cost of goods sold 103,241 72.1 94,876 72.3
Gross profit $ 39,845 27.9 $ 36,350 27.7
Selling expense 14,810 10.3 12,899 9.8
Administrative expense 17,665 12.4 16,757 12.8
Other 1,689 1.2 2,035 1.6
Earnings before taxes $ 5,681 4.0 $ 4,659 3.5
Income taxes 1,747 1.2 1,465 1.1
Net income $ 3,934 2.8 $ 3,194 2.4

Compute common financial ratios.

Common Financial Ratios
 Short-term debt-paying ability
 Liquidity activity ratios
 Ability to meet long-term debt obligations
 Profitability ratios

Short-term Debt-paying Ability
(Cash + Marketable securities)

Cash ratio =
Current liabilities
(Cash + Marketable securities

Quick ratio = + Net accounts receivable)
Current liabilities
Current assets
Current ratio =
Current liabilities

Liquidity Activity Ratios
Accounts receivable Net sales

=
turnover Average gross receivables
Days to collect 365 days
=
receivable Accounts receivable turnover
Inventory Cost of goods sold
=
turnover Average inventory
Days to sell 365 days
=
inventory Inventory turnover
Ability to Meet Long-term Debt
Obligation
Total liabilities
Debt to equity =
Total equity
Times interest Operating income

=
earned Interest expense

Profitability Ratios
Earnings Net income

=
per share Average common shares outstanding
Gross profit (Net sales – Cost of goods sold)

=
percent Net sales
Operating income
Profit margin =
Net sales

Profitability Ratios
Return on Income before taxes

=
assets Average total assets
Return on (Income before taxes

common = – Preferred dividends)
equity Average stockholders’ equity

Summary of Analytical
Procedures
They involve the computation of ratios
and other comparisons of recorded
amounts to auditor expectations.
They are used in planning to understand

the client’s business and industry.
They are used throughout the audit to identify

possible misstatements, reduce detailed tests,
and to assess going-concern issues.
End of Chapter 8

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Audit Planning and

©2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasley 8-1

©2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasley 8-2

2. To help keep audit costs reasonable

3. To avoid misunderstanding with the client

©2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasley 8-3

©2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasley 8-4

Understand the client’s business and industry.

Assess client business risk.

Perform preliminary analytical procedures.

©2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasley 8-5

Understand internal control and assess control risk.

Gather information to assess fraud risks.

Develop overall audit plan and audit program.

©2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasley 8-6

©2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasley 8-7

1. Client acceptance and continuance

2. Identify client’s reasons for audit

3. Obtain an understanding with the client

4. Develop overall audit strategy

©2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasley 8-8

©2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasley 8-9

©2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasley 8 - 10

1. Risks associated with specific industries

©2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasley 8 - 12

 Major sources of revenue

©2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasley 8 - 13

©2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasley 8 - 14

©2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasley 8 - 15

Governance includes the client’s organizational

 Corporate charter and bylaws

In response to the Sarbanes-Oxley Act, the SEC

The SEC also requires companies to disclose

©2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasley 8 - 17

Strategies are approaches followed by the

Auditors should understand client objectives.

 Financial reporting reliability

©2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasley 8 - 18

The client’s performance measurement system

 market share  Web site visitors

Performance measurement includes ratio analysis

©2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasley 8 - 19

©2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasley 8 - 20

Client business risk is the risk that the

 What is the auditor’s primary concern?

©2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasley 8 - 21

Management and governance

Assess risk of material Measurement and performance

©2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasley 8 - 22

It also requires that management certify

©2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasley 8 - 24

Preliminary tests can reveal unusual

©2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasley 8 - 25

©2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasley 8 - 27

Accept client and perform initial planning

 New client acceptance and continuance

 Identify client’s reasons for audit

 Obtain an understanding with client

 Staff the engagement

©2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasley 8 - 28

Understand the client’s business and industry

 Understand client’s industry and external

 Understand client’s operations, strategies,

©2010 Prentice Hall Business Publishing, Auditing 13/e, Arens/Elder/Beasley 8 - 29